McGraw-Hill/Irwin Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 1
The Fundamentals of
Managerial Economics
Introduction
The manager
Economics
Managerial economics defined
Economics of Effective Management
Identifying goals and constraints
Recognize the nature and importance of profits
Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis
Learning managerial economics
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Chapter Overview
Chapter One
Introduction
Chapter 1 focuses on defining managerial
economics, and illustrating how it is a valuable
tool for analyzing many business situations.
This chapter provides an overview of managerial
economics.
How do accounting profits and economic profits
differ?
Why is the difference important?
How do managers account for time gaps between
costs and revenues?
What guiding principle can managers use to maximize
profits?
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Chapter Overview
The Manager
A person who directs resources to achieve a
stated goal.
Directs the efforts of others.
Purchases inputs used in the production of the
firms output.
Directs the product price or quality decisions.
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Introduction
Economics
The science of making decisions in the
presence of scarce resources.
Resources are anything used to produce
a good or service, or achieve a goal.
Decisions are important because scarcity
implies trade-offs.
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Introduction
The study of how to direct scarce resources in the
way that most efficiently achieves a managerial
goal.
Should a firm purchase components like disk
drives and chips from other manufacturers or
produce them within the firm?
Should the firm specialize in making one type of
computer or produce several different types?
How many computers should the firm produce,
and at what price should you sell them?
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Introduction
Managerial Economics Defined
Basic principles comprising effective
management:
Identify goals and constraints.
Recognize the nature and importance of
profits.
Understand incentives.
Understand markets.
Recognize the time value of money.
Use marginal analysis.
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Economics of Effective Management
Economics of Effective Management
The Nature and Importance of Profits
A typical firms objective is to maximize
profits.
Accounting profit
Total amount of money taken in from sales (total
revenue) minus the dollar cost of producing goods
or services.
Economic profit
The difference between total revenue and cost
opportunity cost.
Opportunity cost
The explicit cost of a resource plus the implicit cost of
giving up its best alternative.

1-8
Economics of Effective Management
The Role of Profits
Profit Principle:
Profits are a signal to resource holders
where resources are most highly
valued by society.

1-9
Economics of Effective Management
1-10
Power of
Input Suppliers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Power of
Buyers
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Entry

Substitutes & Complements
Industry Rivalry
Concentration
Price, Quantity, Quality,
or Service Competition
Degree of Differentiation

Level, Growth,
and Sustainability
of Industry Profits

Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Government Restraints
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
Switching Costs
Timing of Decisions
Information
Government
Restraints
Economics of Effective Management
Five Forces and Industry Profitability
Understand Incentives
Changes in profits provide an incentive to
how resource holders use their resources.
Within a firm, incentives impact how
resources are used and how hard workers
work.
One role of a manager is to construct
incentives to induce maximal effort from
employees.
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Economics of Effective Management
Two sides to every market transaction:
Buyer.
Seller.
Bargaining position of consumers and producers
is limited by three rivalries in economic
transactions:
Consumer-producer rivalry.
Consumer-consumer rivalry.
Producer-producer rivalry.
Government and the market.
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Economics of Effective Management
Understand Markets
The Time Value of Money
Often a gap exists between the time
when costs are borne and benefits
received.
Managers can use present value
analysis to properly account for the
timing of receipts and expenditures.
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Economics of Effective Management
Present Value Analysis 1
Present value of a single future value
The amount that would have to be invested
today at the prevailing interest rate to
generate the given future value:
=

1 +


Present value reflects the difference between
the future value and the opportunity cost of
waiting:
=
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Economics of Effective Management
Present Value Analysis II
Present value of a stream of future values

=

1
1 +
1
+

2
1 +
2
++

1 +



or,
=

1 +

=1

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Economics of Effective Management
Consider a project that returns the following
income stream:
Year 1, $10,000; Year 2, $50,000; and Year 3,
$100,000.
At an annual interest rate of 3 percent, what
is the present value of this income stream?

=
$10,000
1 +0.03
1
+
$50,000
1 +0.03
2
+
$100,000
1 +0.03
3
= $148,352.70

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Economics of Effective Management
The Time Value of Money in Action
Net Present Value
The present value of the income stream
generated by a project minus the
current cost of the project:

=

1
1 +
1
+

2
1 +
2
++

1 +


0

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Economics of Effective Management
Present value of decisions that indefinitely
generate cash flows:

=
0
+

1
1 +
1
+

2
1 +
2
+

3
1 +
3
+
Present value of this perpetual income stream
when the same cash flow is generated (
1
=

2
= = ):

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Economics of Effective Management
Present Value of Indefinitely Lived Assets
Profit maximization principle
Maximizing profits means maximizing
the value of the firm, which is the
present value of current and future
profits.
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Economics of Effective Management
Present Value and Profit Maximization
Present Value and Estimating Values of Firms I
The value of a firm with current profits
0
, with
no dividends paid out and expected, constant
profit growth rate of (assuming < ) is:

=
0
+

0
1 +
1 +
1
+

0
1 +
2
1 +
2
+

0
1 +
3
1 +
3
+
=
0
1 +




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Economics of Effective Management
When dividends are immediately paid out of
current profits, the present value of the firm is
(at ex-dividend date):

0

=
0
1 +




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Economics of Effective Management
Present Value and Estimating Values of Firms II
Short-term and long-term profits principle
If the growth rate in profits is less than
the interest rate and both are constant,
maximizing current (short-term) profits
is the same as maximizing long-term
profits.


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Economics of Effective Management
Short-Term versus Long-term Profits
Given a control variable, , of a
managerial objective, denote the
total benefit as .
total cost as .
Managers objective is to maximize net
benefits:
=
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Economics of Effective Management
Marginal Analysis
How can the manager maximize net benefits?
Use marginal analysis
Marginal benefit:
The change in total benefits arising from a
change in the managerial control variable, .
Marginal cost:
The change in the total costs arising from a
change in the managerial control variable, .
Marginal net benefits:
=
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Economics of Effective Management
Using Marginal Analysis
Marginal principle
To maximize net benefits, the manager
should increase the managerial control
variable up to the point where marginal
benefits equal marginal costs. This level of
the managerial control variable corresponds
to the level at which marginal net benefits
are zero; nothing more can be gained by
further changes in that variable.
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Economics of Effective Management
Marginal Analysis Principle I
Marginal Principle II
Marginal principle (calculus alternative)
Slope of a continuous function is the
derivative /marginal value of that function:
=

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Economics of Effective Management
Marginal Analysis In Action
It is estimated that the benefit and cost
structure of a firm is:
= 250 4
2

=
2

Find the and functions.
= 250 8
= 2
What value of makes zero?
250 8 = 2 = 25
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Economics of Effective Management
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Quantity
(Control Variable)
Total benefits
Total costs
0


Maximum total benefits
Maximum net
benefits
Economics of Effective Management
Determining the Optimal Level of a Control Variable
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Quantity
(Control Variable)
Net benefits
0
Maximum
net benefits
Slope =()
= = 0
Economics of Effective Management
Determining the Optimal Level of a Control Variable II
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Quantity
(Control Variable)
Marginal
benefits, costs
and net benefits
0



Maximum net
benefits
Economics of Effective Management
Determining the Optimal Level of a Control Variable III
Incremental revenues
The additional revenues that stem from a yes-or-
no decision.
Incremental costs
The additional costs that stem from a yes-or-no
decision.
Thumbs up decision
> .
Thumbs down decision
< .
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Economics of Effective Management
Incremental Decisions
Learning Managerial Economics
Practice, practice, practice
Learn terminology
Break down complex issues into
manageable components.
Helps economics practitioners
communicate efficiently.
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Learning Managerial Economics
Conclusion
Make sure you include all costs and
benefits when making decisions
(opportunity costs).
When decisions span time, make sure you
are comparing apples to apples (present
value analysis).
Optimal economic decisions are made at
the margin (marginal analysis).
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Conclusion